Topic 9 & 10 Revision Questions Flashcards
Briefly explain how a company determines its target or optimal capital structure.
The target (or optimal) capital structure refers to the optimal mix of debt, preference shares and ordinary equity with which the company plans to use to finance its investment opportunities. The target (or optimal) capital structure for a company is determined by the capital structure that minimizes the overall cost of capital for the company, thereby maximizing the market value of the company, which in turn maximizes the overall wealth of its ordinary shareholders.
Business risk
Business risk is the risk or uncertainty associated with a company’s business operations, ignoring any fixed financing effects. Specifically, business risk refers to the relative variability of a company’s operating income that arise from changes to its cost structure and/or changes to its operating environment (e.g. industry competition). Since changes in operating income affect a company’s profitability and/or financial viability, both preference shareholders and ordinary shareholders are affected by business risk.
Financial risk
Financial risk is the additional risk or uncertainty, over and above the business risk, that is borne by a company’s ordinary shareholders which arises from the manner in which the company’s assets are financed. Specifically, financial risk refers to the additional variability in earnings available to ordinary shareholders that arise from the company’s financing decisions and includes the additional risk of bankruptcy from the use of financial leverage. Since changes in the earnings available to ordinary shareholders affect a company’s ability to make dividend payments to ordinary shareholders, only ordinary shareholders are affected by financial risk.
the three (3) general theories of capital structures that are used to explain corporate decisions relating to the capital structure of a business.
Trade off theory
Signalling theory
Pecking order theory
Trade-off Theory:
Trade-off Theory argues that there is a ‘trade-off’ between the tax benefit versus the bankruptcy-related cost associated with debt financing. Specifically, Trade-off Theory argues that, since interest payments are a tax-deductible expense, the government effectively subsidises part of the cost of debt capital, resulting in more operating income flowing through to shareholders. However, as the company uses greater amounts of debt, the risk of bankruptcy also increases, which results in the company having to pay higher interest rates. Therefore, from the Trade-off Theory’s perspective, the optimal capital structure for a company is the point at which the tax benefit from additional debt exactly offsets the increase in bankruptcy-related cost, thus resulting in the minimum overall cost of capital for the company.
Signalling theory
On the other hand, Signalling Theory argues that, owing to asymmetric information between company managers and external investors, the company management’s choice between debt financing versus equity financing is viewed by market investors as a signal about the company management’s perception of the future financial prospects for the company. Since external investors expect that companies with bright financial prospects will prefer debt financing over equity financing, the decision to use debt financing is viewed as a positive signal by market investors that company managers perceive the company’s future financial prospects to be bright. Conversely, since external investors expect that only companies with poor financial prospects will prefer equity financing, the decision to use equity financing is viewed as a negative signal by market investors that company managers perceive the company’s future financial prospects to be poor. Accordingly, the implication of Signalling Theory is that companies should always maintain a reserve borrowing capacity by using less debt than the ‘optimum debt level’ suggested by Trade-off Theory in order to ensure that further debt capital can be obtained later if required.
Pecking order theory
Since external investors know that company managers will attempt to issue new equity when they perceive the company’s shares as overpriced, market investors will necessarily discount the price that they are willing to pay for the company’s shares by underpricing the company’s shares. Pecking Order Theory argues that, to avoid this underpricing, company managers prefer to finance investment opportunities using retained earnings, followed by debt financing, and will only choose equity financing as last resort.
The relative advantages of debt financing compared to equity financing are as follows:
Maintaining ownership and control:
Tax deductions:
Lower interest rates:
Maintaining ownership and control:
Unlike equity financing, debt financing does not involve selling claims to ownership of the business to market investors. As such, by using debt financing, the owner is able to maintain ownership and control over the business.
Tax deductions:
Unlike the dividend payments associated with equity financing, the interest payments associated with debt financing are tax deductible, with the government effectively subsidising part of the cost of debt capital.
Lower interest rates:
Since debtholders usually demand lower returns (in the form of lower interest rates) than ordinary shareholders, debt financing is typically cheaper than equity financing.
The relative disadvantages of debt financing compared to equity financing are as follows:
Repayment obligations:
Risk of bankruptcy:
Need for collateral:
Repayment obligations:
With debt financing, there is a need to make periodic fixed repayments to the debt holder on a regular basis. As such, the business must ensure that it can generate sufficient cash flows to meet the repayments when they fall due or face becoming bankrupt. There is, however, no such repayment obligation with equity financing.
Risk of bankruptcy:
Debt financing increases the risk of bankruptcy for the business. Furthermore, in the event the business becomes bankrupt, the debt holder has priority in claiming the assets of the business before ordinary shareholders. There is, however, no such risk of bankruptcy with equity financing.
Need for collateral:
With debt financing, the business is usually required to pledge some of its assets as collateral in order to protect the debt holder against possible default. There is, however, no such requirement for collateral with equity financing.
Capital Structure
The combination of debt and equity used to finance a company’s assets.
Total Assets
Total Liabilities (debt financing) + Total Equity (equity financing).
Operating leverage
Operating Leverage refers to the presence of fixed operating costs (as opposed to variable operating costs) within a company’s cost structure.
A company with relatively high fixed operating costs will experience greater variability in operating income if sales were to change.
Fixed-cost sources of finance:
Debt
Preference shares
Variable-cost sources of finance:
Ordinary shares
Explain why bond prices have an inverse relationship with interest rate movements.
Since the coupon rate of a bond is fixed until maturity, the price of a bond will vary according to interest rate movements in the market. If the coupon rate is the same as the market interest rate, then the bond will sell for its par value (i.e. a ‘par bond’).
However, if the coupon rate is greater than the market interest rate, then there will be increased demand for the bond which causes an increase in the market price of the bond, resulting in the bond selling for a premium (i.e. a ‘premium bond’).
Conversely, if the coupon rate is less than the market interest rate, then there will be decreased demand for the bond which causes a decrease in the market price of the bond, resulting in the bond selling for a discount (i.e. a ‘discount bond’).
In this way, bond prices are said to have an inverse relationship with interest rate movements, with bonds prices increasing when market interest rates decline and bond prices decreasing when market interest rates rise.
Explain why preference shares are considered as a form of hybrid security.
Preference shares are considered as a form of ‘hybrid security’ because preference shares possess some features that are similar to bonds and some features that are similar to ordinary shares.
On the one hand, preference shares are similar to bonds in that fixed dividends must be paid to preference shareholders before dividends can be paid to ordinary shareholders. On the other hand, preference shares are similar to ordinary shares in that preference shares have no fixed maturity date and there is no obligation for companies to pay dividends to preference shareholders. In other words, companies can omit dividend payments to preference shareholders without the fear of defaulting and pushing the company into bankruptcy.
Explain why a company’s ordinary shareholders are often referred to as its residual claimants.
As ‘residual claimants’, ordinary shareholders have residual claims to any earnings that remain only after: (i) interest payments are made to debt holders; (ii) corporate tax is paid to the government; and (iii) dividends are paid to preference shareholders.
Additionally, in the event a company becomes bankrupt, ordinary shareholders have residual claims to any assets that remain only after: (i) all claims by debt holders are settled; and (ii) all claims by preference shareholders are settled.
the dividend payment
process:
(a) Declaration date;
(b) Cum dividend;
(c) Ex-dividend date;
(d) Record date;
(e) Payment date.
(a) Declaration date;
Declaration date is the date on which the company’s board of directors publicly announces the amount and the specifics (such as the payment date) of the next dividend payment.
(b) Cum dividend;
Cum dividend refers to the situation where the legal right to the next dividend payment accompanies a share. When investors purchase shares that are cum dividend, they are entitled to receive the next dividend payment on the payment date. Conversely, when shareholders sell shares that are cum dividend, they will not be entitled to receive the next dividend payment on the payment date.
(c) Ex-dividend date;
Ex-dividend date is the date on which the legal right to the next dividend payment no longer accompanies a share. In Australia, the ex-dividend date occurs 4 business days prior to the record date when the company finalises the list of shareholders that will receive the next dividend payment. Accordingly, shareholders that sell shares on or after the ex-dividend date will still be entitled to receive the next dividend payment on the payment date, although the new owner will not. Usually, shares that trade immediately after the ex-dividend date will be accompanied by a decline in the share price that is equivalent to the amount of the next dividend payment.
(d) Record date;
Record date is the date on which the company determines the list of shareholders that will receive the next dividend payment. In Australia, the record date occurs 4 business days after the ex-dividend date.
(e) Payment date.
Payment date is the date on which the company actually makes the dividend payments to the shareholders on its record.
Does dividend policy affect the share price of a company?
There are two opposing viewpoints with respect to how dividend policy decisions affect the share price of a company:
Dividend Irrelevance Theory
Dividend Relevance Theory
Dividend Irrelevance Theory
Dividend Irrelevance Theory states that a company’s dividend policy is irrelevant and has no effect on the overall cost of capital nor the market value of the company. Specifically, Dividend Irrelevance Theory argues that the market value of a company is determined by the basic earning power and the business risk of the company. Therefore, the market value of a company depends only on the net income (or positive cashflows) produced by the company and not on how it splits its retained earnings between financing investments for future growth versus dividend payments to shareholders. As a result, Dividend Irrelevance Theory contends that investors are only concerned with the total returns they receive, and not whether they receive those returns in the form of dividends, capital gains or both.
Dividend Irrelevance Theory practical implication
Since Dividend Irrelevance Theory argues that shareholders are not concerned with a company’s dividend policy, this implies that company managers can set any dividend policy without affecting the company’s share price.
Dividend Relevance Theory
In contrast, Dividend Relevance Theory states that the market value of a company is affected by its dividend policy, with the optimal dividend policy being the one that maximises the market value of the company. Specifically, Dividend Relevance Theory contends that a company’s dividend policy can affect its market value due to investor preferences for either dividends (as ‘bird-in-hand’ theory contends) or capital gains (as ‘tax preference’ theory contends):
Bird-in-Hand’ Theory:
The ‘Bird-in-Hand’ Theory argues that, since current dividend payments are more certain
than future capital gains, investors would prefer to receive dividends today rather than
receive capital gains in the future.
Bird-in-Hand’ Theory: Practical implication
Since ‘Bird-in-Hand’ Theory argues that investors prefer to receive dividend payments
today rather than capital gains in the future, this implies that company managers ought to
set a high regular dividend payments policy so as to minimize the cost of equity and
maximize the company’s share price.
‘Tax Preference’ Theory:
On the other hand, the ‘Tax Preference’ Theory argues that, since dividends are taxed
immediately whereas capital gains are not taxed until the share is sold (with potentially
indefinite deferral of tax), investors would prefer to defer tax by receiving capital gains in
the future rather than receiving dividends today and being taxed immediately.
Tax preference theory Practical implication
Since ‘Tax Preference’ Theory argues that investors prefer to defer tax by receiving
capital gains in the future rather than receiving dividends today, this implies that company
managers should set a low regular dividend payments policy so as to minimise the cost of
equity and maximise the company’s share price.
types of
dividend policies:
(a) Residual dividend policy;
(b) Constant payout ratio dividend policy;
(c) Stable dollar dividend policy;
(d) Low regular dividend plus extras dividend policy.
(a) Residual dividend policy;
Residual dividend policy refers to a policy in which the company only makes dividend payments to shareholders when there is retained earnings left over after having financed all profitable investment opportunities. In other words, the residual dividend policy dictates that dividend payments to shareholders should only be paid out of leftover earnings.
(a) Residual dividend policy; implication
Although the residual dividend policy minimizes the cost of capital for the company by reducing the need to raise funds through the issuance of new equity or shares (which represents the most expensive form of financing), the residual dividend policy will necessarily result in the variation of dividend payments to shareholders due to fluctuations in both the amount of retained earnings and the cost of pursuing profitable investment opportunities over time. Since investors value economic certainty, this variation or instability of dividend payments sends conflicting signals to investors that might, in turn, adversely affect the company’s share price.
(b) Constant payout ratio dividend policy;
Constant payout ratio dividend policy refers to the policy in which the company distributes a fixed proportion of its earnings to shareholders in the form of dividend payments (for example, if the board of directors declare a constant payout ratio of 30%, then, for every dollar of earnings, 30 cents will be paid out to shareholders as dividends).
(b) Constant payout ratio dividend policy; implication
Although the dividend payout ratio remains constant over time, the dollar value of dividend payments will necessarily fluctuate as earnings change over time. Again, this fluctuation in dividend payments sends conflicting signals to investors that might, in turn, adversely affect the company’s share price.
(c) Stable dollar dividend policy;
Stable dollar dividend policy refers to the policy in which the company pays a fixed dollar amount of dividend payments to shareholders each year such that the annual dollar dividend is relatively predictable for investors.
(c) Stable dollar dividend policy; implication
Since investors value economic certainty, the stability and predictability of dividend
payments sends a positive signal to investors that will, in turn, help to attract more
investors, thereby maintaining or boosting the company’s share price.
(d) Low regular dividend plus extras dividend policy.
Low regular dividend plus extras dividend policy refers to the policy in which the company pays a low regular dollar dividend to shareholders plus an extra (or special) year-end dividend in prosperous years when the company is performing well financially.
(d) Low regular dividend plus extras dividend policy. implication
The ‘low regular dividend plus extras’ dividend policy represents a compromise between the stable dollar dividend policy and the constant payout ratio dividend policy in that it provides the company with flexibility while ensuring that shareholders receive at least a minimum amount of dividend payment. Specifically, by identifying the year-end dividend as an ‘extra’, the company avoids signalling to investors that this is a permanent dividend, thereby providing the company with the flexibility to reduce or eliminate the year-end dividend in the future without adversely affecting its share price.
Share repurchases
Share repurchases (or share buy-backs) refers to the distribution of earnings by a company to
its shareholders by purchasing its own shares from existing shareholders. There are two main
forms of share repurchases in Australia: (a) on-market repurchase; and (b) off-market
repurchase
(a) on-market repurchase
. On-market repurchase involves the company purchasing shares offered for sale
by investors on the share market through the normal share market trading mechanism.
(b) off-market
repurchase
off-market repurchase involves the company making a formal offer to all existing
shareholders to purchase shares from them based on the offer terms outlined in the offer
document. As such, off-market repurchases are not processed through the normal share
market trading mechanism.
The primary reasons why a company would choose to engage in share repurchases to
repurchase its own shares include:
To distribute excess funds to shareholders
To adjust the company’s capital structure
To adjust for employee options or employee share-based compensation
To protect or defend against a hostile takeover attempt
To distribute excess funds to shareholders
To distribute excess funds to shareholders especially when the company’s share price is perceived to be under-valued;
To adjust the company’s capital structure
To adjust the company’s capital structure when the company has more equity than its target capital structure suggests;
To adjust for employee options or employee share-based compensation
To adjust for employee options or employee share-based compensation by reducing the dilution effect that occurs when employee options are exercised, thereby ensuring that the company’s overall issued capital does not change markedly
To protect or defend against a hostile takeover attempt
To protect or defend against a hostile takeover attempt by: (a) driving up the share price, thus making it more costly for other parties to acquire the company; and (b) concentrating the ownership of the company’s shares in the hands of company management and/or other shareholder groups that wish to fend off the hostile takeover.
From the perspective of company managers, the relative advantages of share repurchases compared to regular dividend payments are as follows:
(1) To distribute excess cash to shareholders:
(2) To adjust the company’s capital structure:
(3) To adjust for employee share-based compensation:
(4) Signal to investors:
(1) To distribute excess cash to shareholders:
Unlike regular dividend payments, share repurchases provide flexibility by allowing companies to distribute excess cash to shareholders without changing the amount of regular dividend payments.
(2) To adjust the company’s capital structure:
Unlike regular dividend payments, share repurchases are an effective method to immediately change the company’s capital structure when the proportion of equity is substantially higher than the target capital structure prescribes.
(3) To adjust for employee share-based compensation:
Unlike regular dividend payments, share repurchases reduce the dilution effect that occurs when employee options are exercised, thereby minimising the effect on the company’s share price.
(4) Signal to investors:
Unlike regular dividend payments, share repurchases allow company managers to signal to investors that they perceive the company’s share price to be under-valued, and thus represent a bargain for investors to purchase.
From the perspective of company managers, the relative disadvantages of share repurchases compared to regular dividend payments are as follows
(1) Company might overpay for shares:
(2) Irregular interval between share repurchases:
(1) Company might overpay for shares:
With share repurchases, the company might end up paying too much for the purchased shares.
This is especially so when substantial amounts of shares are purchased on the market,
which might in turn cause a marked increase in the company’s share price.
(2) Irregular interval between share repurchases:
Since the interval between share repurchases are generally irregular, participating investors
cannot rely on the cash that they receive from share repurchases. As a result, some investors
might prefer cash distribution through regular dividend payments rather than through share
repurchases by the company.
Sources of finance
Equity financing
Debt financing
Equity financing
Equity holders have a residual claim to the cashflows
generated by the assets of the company.
e.g. ordinary shares; preference shares
DEBT FINANCING:
Debt providers have a contractual right to the cashflows
generated by the assets of the company.
e.g. term loans (long-term bank loans); debentures;
bonds (government bonds and/or corporate bonds)
A bond
A bond refers to a contract that is issued by either a government or a corporation (the issuer) promising to pay the holder:
(1)A pre-determined amount of interest payments;
and
(2) The face value at maturity.
A bond represents
A bond represents a form of interest-only direct
finance loan.
A bond pays
A bond pays fixed coupon payments at fixed intervals and pays the par value at maturity
Bond terminology
Par value (or face value)
Maturity date
Coupon rate
Coupon payments
Par value (or face value)
- The principal amount to be repaid on the maturity date.
Maturity date
The date at which the principal amount is payable.
Coupon rate
The annual coupon payments divided by the face value.
Coupon payments
- The fixed interest payments that are payable at fixed intervals
until the maturity date.
Valuation of Bonds
Valuation of Bonds
The expected cash flows for a bond consist of:
(1) All coupon payments (paid at fixed intervals until the maturity date);
and
(2) The principal amount or Face Value (paid at the maturity date).
VALUATION OF BONDS
General Rule:
If the Coupon rate = Interest rate:
The bond will sell for its par value (i.e. par bond).
If the Coupon rate > Interest rate:
The bond will sell for a premium (i.e. premium bond).
If the Coupon rate < Interest rate:
The bond will sell for a discount (i.e. discount bond).
VALUATION OF BONDS CONCLUSION
Bond prices are inversely related to interest rate movements:
- If interest rates increase, bond prices will fall and thus sell at a discount; and - If interest rates decrease, bond prices will rise and thus sell at a premium.
Time Path of the Value of a 10% coupon, $1,000 Par Value Bond When Interest Rates are 8%, 10% and 12%
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Preference shares are:
A form of hybrid security;
Similar to bonds in that fixed dividends that must be paid to preference shareholders before dividends can be paid to ordinary shareholders;
Similar to ordinary shares in that preference shares have no fixed maturity date and there is no obligation for companies to pay dividends to preference shareholders:
Par value
Establishes the amount due to preference shareholders in the event of company liquidation event;
The preference dividend is generally set as a % of par value.
Valuation of preference shares formula
PV = D / r
where:
D = Fixed dividend payment for each year
(in dollars);
r = Required rate of return
(i.e. interest rate or discount rate).
Ordinary shares
Ordinary shares represent equity or claims to ownership of the company. Ordinary shares are variable-income securities
Divided growth model formula (ordinary shares)
PV = D / r - g
where:
D = Dividend payment (in dollars);
r = Required rate of return
(i.e. interest rate or discount rate);
g = Growth rate (of dividend).
Dividend
A dividend is a payment that is made out of a company’s (retained) earnings to its owners (or shareholders). Dividends are usually paid in the form of cash.
There are many analysis tools used to conduct a financial analysis. The three most common are:
Horizontal analysis
Vertical analysis
Ratio analysis
Horizontal analysis
Also known as trend analysis. It is a technique that calculates the change in an account balance from one period to the next and expresses that change in both dollar and percentage terms. It is a simple but powerful analysis tool. It reveals significant changes in account balances and therefore identifies items for further investigation.
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Vertical analysis
Vertical analysis is a technique that states each account balance on a financial statement as a percentage of a base amount on the statement.
It also allows comparisons of different companies (and the same company over time) by controlling for differences in size.
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Ratio analysis
Profitability – Measure of success in wealth creation
Liquidity – The ability to meet short-term obligations
Solvency – The ability to satisfy its long term obligations
Profitability analysis
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Return on equity
The return on equity ratio compares profits to the average balance in shareholders’ equity, showing how effectively a company uses the funds provided by shareholders during the year to generate additional equity for its owners.
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Profit margin ratio
The profit margin ratio compares net income to net sales and measures the ability of a company to generate profits from sales. A higher ratio indicates a greater ability to generate profits from sales.
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Return on assets
The return on assets ratio compares income to average total assets
It represents the ability to generate profits from its entire resource base (not just those resources provided by owners).
Measures overall profitability with respect to investment in assets
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Price earnings ratio
The price to earnings ratio compares income to the current market price of the company’s shares, it is an investor’s perception of the company.
A price earnings ratio of 10 means that investors pay ten times current EPS share to buy one share.
A higher price to earnings ratio generally indicates that investors are more optimistic about the future prospects of a company.
Profitability ratios
Measure the profit or operating success of an entity for a given period of time. Profitability is often regarded as the ultimate test of management’s operating effectiveness.
Liquidity analysis
A business’s inability to pay interest and to repay the liabilities is the reason why businesses are placed into administration.
Directors may be personally liable if they allow a company to trade while it is insolvent.
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Current ratio
The current ratio is one of the most frequently used ratios in financial analysis and compares current assets to current liabilities. It compares assets that should be turned into cash within one year to liabilities that should be paid within one year. A higher ratio indicates greater liquidity.
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Quick ratio
The quick ratio (the acid-test ratio) compares a company’s cash and near-cash assets, or quick assets, to its current liabilities.
It also measures the degree to which a company could pay off its current liabilities immediately, a higher quick ratio indicates greater liquidity.
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Receivables turnover
Indicates the effectiveness of credit collection policies.
Measures the number of times trade receivables are converted into cash during the period
The higher the receivable turnover, the shorter the period of time between an entity making credit sales and collecting the cash for the receivable
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Inventory turnover ratio
The inventory turnover ratio measures the number of times on average the inventory sold during the period. Its purpose is to measure the liquidity of the inventory
Inventory turnover is produce specific. A higher ratio is usually desirable.
Reflects the effectiveness of inventory management
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Solvency analysis
Solvency refers to a company’s ability to remain in business over the long term and satisfy its long-term obligations. Solvency is related to liquidity but differs with respect to time frame.
It isn’t possible to know if a company will be able to pay future obligations and remain solvent, although some indication of a company’s general solvency include:
debt to assets
debt to equity
times interest earned
debt to assets
debt to equity
times interest earned
These ratios show how a company uses leverage, to create greater returns to shareholders, but also greater solvency risk.
Solvency and financial leverage
Financial leverage is the degree to which a company obtains capital through debt rather than equity in an attempt to increase returns to shareholders.
DuPont analysis
A DuPont analysis provides insight into how a company’s return on equity was generated by decomposing the return into three components: operating efficiency, asset effectiveness and capital structure.
3 components of DuPont calculation
- Operating Efficiency
- Effectiveness at using assets
- Business’s capital structure
- Operating Efficiency
calculated as total comprehensive income (net income) divided by sales (the profit margin ratio). This is the ability to turn sales into profits. The higher the ratio, the more efficient a company is in turning sales into profits.
- Effectiveness at using assets
calculated as sales divided by assets (asset turnover ratio). This is the ability to generate sales from assets. The higher the ratio, the more effective a company is in generating sales given its assets.
- Business’s capital structure:
calculated as assets divided by equity. This ratio is similar to the debt to assets and debt to equity ratios in that it measures how a business has financed its assets. The higher the ratio, the more financing with debt rather than equity. A high ratio means more financial leverage, a riskier capital structure. This ratio is sometimes called the leverage multiplier.
DuPont analysis diagram
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Triple-bottom-line reporting
A reposting framework that is more comprehensive than traditional financial performance measure
Integrate financial, environmental and social performance of an entity
